Financial markets

Markets and economics

Gentlemen beware bonds

ECONOMISTS and investors are always looking out for early warning signs of recession, so here is one to watch for - corporate bond spreads. David Ranson of Wainwright Economics says a rise in spreads is usually a sign of a global slowdown. Like him, our graph uses the Baa corporate bond spread over (7-year) Treasury yields.

We go back 40 years and the shaded periods indicate US recessions, as defined by the NBER. As you can see, sometimes spreads started rising before the downturn and sometimes the move was coincident. Either way, the signal isn't good. And it is worth remembering that the NBER tends to call a recession quite a long time after it actually began. The current move in spreads is about one percentage point; previous shifts have been two points or more so this is not a decisive signal, yet.

Why might the signal work? As the economy slows, companies start to feel the effect and revise down their profits outlook; Caterpillar was a case in point yesterday. That makes investors nervous about credit risk and they demand a higher return for owning corporate bonds. When recession actually hits, more companies default and the spreads rise even further. The 2008-2009 period was quite remarkable in this respect; as the graph shows, spreads rose to their highest level since the 1930s but fortunately defaults were nothing like as bad.

It is worth noting, however, that spreads are currently higher than they were at any time before the past decade. Of course, that is in part a symptom of record-low Treasury yields. But it also shows why QE has only had a limited effect in persuading companies to borrow and invest.

"As you can see, sometimes spreads started rising before the downturn and sometimes the move was coincident."

And sometimes they spiked after the downturn, as in '83, '86, '92 and '03, without any recession following closely enough afterwards to be considered statistically significant. What I see in the past fifteen years are spikes followed by drops and then plateaus for a few years. In '94 to '98 and '04 to '06 the spread was about 2%, and we're about twice that right now, but it's still a plateau about one to three points below the spike. I'm unconvinced that this chart means much.

1) Not every rise was followed by a recession ('84-'86 for example) and 2) with the underlying treasury at all-time lows, investors require a minimum level of coupon, which (partially) explains why the spread level has been rising since the crisis. While spreads have been rising, the underlying is dropping, leaving the cost to issuers generally flat.

The situation is not unlike th post-2001-2002 recession period when treasury yields were kept low by the Fed. If the US debt market can return to some semblance of normalcy, (a big if,) I would expect credit spreads to narrow.
Another indicator for recessions is an inverted yield curve. Although the treasury yield curve is relatively flat, I don't think we're all screwed until the Fed is forced buy up long-dated treasuries in QE4, QE5 or QE6.